Block 4 Section 3 (Part I) The impact of innovation on business functions Prepared by Hanady Ali Osman

2 H.A.Osman Innovation in Accounting & Finance Capital investment model Innovation in Accounting & Finance Capital investment model (Page 34 binder) Implementation Analysis and Acceptance Monitoring and Post-audit Identification of potential investments Project definition And screening Formal CI systems Strategic Planning Organisational personnel Organisational environment Feedback

3 H.A.Osman Investment appraisal in organizational life Investment appraisal in organizational life (Pg. 39/40 Binder) Lumijarvi (1991) investigated the methods used by project champions to convince fund-holders within organizations. He classified their judgments into four main types of arguments:  Economic arguments  Strategic arguments  Non-economic arguments  Production technology arguments

4 H.A.Osman Companies should accept innovations where: Companies should accept innovations where: (Page 34 binder) Benefits > Costs Revenues Reduction in costs Economic and social benefits to donor-or- tax-funded public service users Expenditure of the innovating organisation Environmental & social costs.

5 H.A.Osman CIA Techniques CIA Techniques (Page 267 text) Models for profit-making firms:  The payback period (PP) method.  Accounting rate of return (ARR)  The net present value (NPV) method  The internal rate of return (IRR) method

6 H.A.Osman CIA Techniques CIA Techniques (Page 43 Binder) Models for non- profit or tax-funded firms:  Cost-benefit analysis  Cost-effectiveness analysis

7 H.A.Osman Why do investment decisions tend to be more important to investors?

8 H.A.Osman Importance of Investment decisions to investors Large amounts of resources are often involved; if mistakes are made with the decision, the effects on the business could be significant It is often difficult and/or expensive to ‘bail-out’ of an investment once it has been undertaken

9 H.A.Osman Accounting Rate of Return (ARR) Method Accounting Rate of Return (ARR) Method (Page 269 text) The ARR method takes the average accounting profit that the investment will generate and expresses it as a percentage of the average investment in the project as measured in accounting terms.

10 H.A.Osman Accounting Rate of Return (ARR) Method Accounting Rate of Return (ARR) Method (Page 269 text) ARR = Average annual profit Average investment to earn that profit X 100%

11 H.A.Osman Accounting Rate of Return (ARR) Method e.g. a three-year project with a projected net income of $100 in year1, $2000 in year2, and $4000 in year3. The cost is $9000 which will be depreciated by straight line method over the project life. The salvage value equals to zero. What is the ARR.?

12 H.A.Osman Accounting Rate of Return (ARR) Method Note that average investment = (cost + salvage value)/2. Decision-rule: if ARR >ROE, then we accept the project.

13 H.A.Osman Advantages of ARR method Advantages of ARR method (Page text) 1. A measure of profitability that many believe is the correct way to evaluate business. 2. Produces % figure of return that manager feel comfortable with 3. Easy to compare % returns on different investments to help make a decision 4. Links in with ROE as a method of measuring business performance

14 H.A.Osman Disadvantages of ARR method Disadvantages of ARR method (Page text) 1. Focuses on accounting profitability rather than cash flows 2. Ignores time value of money (opportunity cost) 3. Create problems when considering different investments’ size

15 H.A.Osman Payback period method Payback period method (Page 273 text) The PP method is the length of time it takes for the initial investment to be repaid out of the net cash inflows from the project.

16 H.A.Osman Payback period method Payback period method (Page 273 text) Net cash Cumulative flow cash flows flow cash flows Immediately (Cost of machine) (100)(100) 1 years’ time (NP before dep.) 20 (80) 2 years’ time (NP before dep.) 40 (40) 3 years’ time (NP before dep.) years’ time (NP before dep.) years’ time (NP before dep.) years’ time (Disposable proceeds) Payback period = 2 2/3 years Payback period = 2 2/3 years

17 H.A.Osman Advantages of PP method Advantages of PP method (Page text) 1. Quick and easy to calculate 2. Easily understood 3. Focuses upon the short run, thus avoids the problems of forecasting far into the future. 4. An improvement on ARR in respect of the timing of the cash flows. 5. It emphasizes the importance of liquidity

18 H.A.Osman Disadvantages of PP method Disadvantages of PP method (Page text) 1. Not a measure of profitability 2. PP ignores the timing of the cash flows 3. Ignores cash flows beyond the payback period 4. PP cannot distinguish between projects having the same payback period 5. Not a suitable measure to deal with risk

19 H.A.Osman Example of PP for 3 projects Example of PP for 3 projects (Page 274 text) TimeCash flow Project 1 Cash flow Project 2 Cash flow Project 3 Immediately (time 0)(200) 1 year’s time year’s time year’s time year’s time year’s time year’s time401020

H.A.Osman Factors influencing the discount rate to be applied to a project (Page text) Discount rate Inflation Risk premium Interest foregone

21 H.A.Osman Discounted cash flows techniques Discounted cash flows techniques (Page 275 text) These are appraisal methods that take account of all the costs and benefits of each investing opportunity which, also makes a logical allowance for the timing of those costs and benefits.

22 H.A.Osman Net Present Value method Net Present Value method (Page 281 text) This method calculates the present value of all the money coming in from the project in future and then sets it against all the money being spent on the project today. Projects are only worth carrying out if the NPV is positive-otherwise just put your money in the bank and earn some interest.

23 H.A.Osman Net Present Value method Net Present Value method (Page 281 text) TimeCash flowCalculation of PV PV Immediately (time 0)(100)(100)/(1+0.2)0(100) 1 year’s time2020/(1+0.2) year’s time4040/(1+0.2) year’s time6060/(1+0.2) year’s time6060/(1+0.2) year’s time2020/(1+0.2) year’s time2020/(1+0.2)

24 H.A.Osman Net Present Value method Net Present Value method (Page 281 text) The decision taken by the NPV is: If NPV is positive the project is accepted If NPV is negative the project is rejected

25 H.A.Osman Using discount tables Using discount tables (Page 281 text) Discount tables are easier ways to calculate the present value of various discount rates (r) over different periods of time (n), instead of calculating each 1/(1+ r)ⁿ through: 1/(1+ r)ⁿ

26 H.A.Osman Advantages of NPV (Pg. 283 text) 1. Considers timing of the cash flow 2. Takes the opportunity cost of money into account 3. A single measure takes the amount and timing of cash flows into account 4. Can consider different scenarios i.e. what if? 5. Takes account of business objectives- assumed to be profit maximising. Positive NPVs enhance wealth whilst negative reduces wealth.

27 H.A.Osman Disadvantages of NPV 1. Complex to calculate and communicate 2. The meaning of the result is often misunderstood 3. Only comparable between projects if the initial investment is the same